Investing in Materials Means Navigating a World of Cyclical Price Takers

The materials sector is often overlooked, but its cyclical nature means materials producers can do quite well during an economic upswing.

Materials companies are generally capital intensive: this can present challenges when it comes to generating returns.

Active management allows us to identify the best investment opportunities in this growing sector.

In a world dominated by headline-grabbing FAANG stocks (Facebook, Amazon, Apple, Netflix and Google), the materials sector is easy to overlook. The companies it includes often produce just inputs, like fertilizer or other raw materials, not end products like cool new mobile phones or self-driving vehicles.

If you make the coolest new phone, you have a high degree of flexibility in setting your price for that phone. But for many materials producers, this situation is reversed. Many of these companies are considered price takers” because they are in highly commoditized or indistinguishable businesses like steel, which means they must take prevailing market prices for what they produce.

But this doesn’t mean that materials should be overlooked. Materials producers tend to follow the ups and downs of the economy; that’s why they are called cyclicals. So if the economy is on an upswing, “boring” price takers can do quite well.

Generating returns can be challenging in a high-cost sector

I understand why investors gravitate to news about the latest iPhone and ignore what’s happening in less glamorous parts of the market, like materials. The materials sector includes companies that manufacture chemicals, construction materials, glass, paper, and forest products and related packaging products. It also includes metals, minerals and mining companies, including steel producers.

Materials make up about 17% of the market weighting of the benchmark S&P/TSX Composite Index. In Canada, gold plays an outsized role, accounting for about 50% of the sector. By contrast, the MSCI All Country World Index (ACWI) is more diverse, and materials make up about 5% of the globe’s investable opportunities.

In addition to not being exciting, materials companies are generally capital intensive; gold mining, for example, involves lots of energy and large, complex facilities to produce it. Being capital intensive can present challenges when it comes to generating returns over the cost of that capital. On the positive side, however, the large upfront costs, gold’s scarcity and the complexity of operations keep competition to a minimum. You can’t start a gold mine in your backyard, but you could create the next Facebook in your basement. A closer look at materials shows why they can play an important role in investment portfolios. In addition to their ability to ride on the coattails of a growing economy, some of these companies manage to be price makers.

With the right investment research, we can give these cyclical price makers a productive role in our portfolios. Recently, I was speaking with Jorg Hampel, an equity analyst at Mawer Investment Management Ltd. and an asset manager for the MD International Growth Fund and the MDPIM International Equity Pool. We were talking about his approach to the materials sector and the names that Mawer likes.

Air Liquide, Agrium and PotashCorp can be price makers

Jorg and his colleagues like to highlight their risk-averse investment approach. He explained that because so many materials companies have plain-vanilla reputations, they are an almost perfect fit for this cautious approach.

One of the materials companies we invest in is Air Liquide, which is the world leader in industrial gases, technologies and services for industry and health. The company operates in 80 countries with about 67,000 employees, and serves more than three million customers and patients. Air Liquide Canada is one of the largest producers of pharmacopoeia-grade gases used in hospitals and medical clinics. It specializes in deconstructing the air around us into important pure gas components.

Unlike other materials companies, Air Liquide can be an effective price maker because it builds plants under contract with customers. The investments in these plants tend to pay off in 15 years, but they can operate for about 30 years. This helps generate returns above the cost of capital. It also gives Air Liquide local monopolies, and the ability to set prices, based on owning infrastructure. In the 10 years ending December 31, 2016, Air Liquide averaged an 8.7% annual return.

Two other great materials holdings that we own, in the MD Dividend Growth Fund and the MDPIM Dividend Pool, are Agrium and PotashCorp. These two companies are held across nine of our funds in varying degrees. The two have inked a merger, which will see them create a world-leading, integrated global supplier of fertilizers and other crop inputs.

Bill Otton, Vice President of Canadian Equities at our asset manager Beutel Goodman, said the new combined company will be in an excellent position to realize about $500 million in savings through streamlining the two organizations. PotashCorp has also seen several years of capital investment in infrastructure, which will begin to pay dividends. Both these factors will help free cash flow and give the company a leg-up when it comes to generating returns above the cost of capital.

Agrium also has an extensive retail business, which allows for some price setting and gives an important window into the needs of farmers and other end-users.

Materials can be an inflation hedge

Most hard assets, including materials, can be an excellent inflation hedge. Gold, for example, has long had this reputation. In Canada, gold can’t be ignored because it is about half of the TSX materials sector market cap. But our experience shows that gold companies are not always the best companies to invest in because of their stock’s potential for big price swings, and their lower returns on capital through time.

Gold does, however, speak to the importance of active management when investing in materials. The importance of when you enter and exit the gold market can’t be overstated, as is the case for other materials that can be subject to big price swings.

The outlook for the materials sector is mostly positive

The sharp commodity price decline seen over the past couple of years appears to be ending, and prospects for the materials sector may be improving. Demand from the United States and developing countries shows a continued need for more raw materials to support their infrastructure plans. A slightly improving European economy is another potential positive for the materials sector.

Additionally, some indebted governments have scaled back their austerity plans and are focusing more closely on generating economic growth through large infrastructure investments. This could provide a significant tailwind for the materials sector.

Active management remains key

I believe that all investment decisions benefit from a prudent, experienced investor conducting appropriate analysis and considering the risk and return trade-off. This experience is of utmost importance when considering investments in the materials sector: we believe an assessment of long-term profitability and prudent pricing of the investment are key to decent returns.

And while some of what materials have to offer falls into the boring category, delivering solid investment performance is never dull. Taking an active and selective approach in materials can really pay off.

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